Prediction: the Cisco-Huawei IP debacle repeated itself with Denso, and likely for the same reasons

In briefings three years ago to some of the largest tier one automotive suppliers, we forecast that Toyota/Denso would be the wholesale Automotive OEM target for IP theft as it was one of the few (the only significant) OEM that retained the capacity to design and manufacture everything that they purchased. (All other OEMs were in the process of surrendering their production technology via joint ventures so the only items worthy of hostile collection were their vehicle designs, preferably the mathdata CAD files thereof.) Another forecast was that any Toyota/Denso JV with a Chinese entity would be an IP siphon to the Chinese. The first forecast has now come true, and is likely only the beginning of the loss. The second is undoubtedly in progress.

In March Kyodo News reported that a Chinese engineer, Yang Luchuan, 41, at Denso's facility in Kariya, Aichi Prefecture, was suspected of "embezzling [Dowjones prefers "stealing"] information on about 1,700 types of products, including sensors and industrial robots [of which] about 280 types were considered top secret by the company."

This theft was discovered after the fact during an "internal investigation following a problem with its database system" which could mean that Yang was discovered by accident or that other means and methods were being concealed. In a classic piece of insider theft:

Yang made repeated downloads from Denso corporate libraries between October-December 2006 to a Denso-supplied laptop

Forensic analysis showed subsequent copying of the files from the laptop to as yet undiscovered external storage devices

Yang made at least three trips to China following the downloads including one ( 16 Feb-4 March) two days after being by Japanese authorities.

Yang took the laptop home but denied the copying disclosed by forensics

Yang destroyed the hard drive of his home computer

The Denso theft again reinforces our maxim that IP holders must protect an asset 'wherever it appears in the global supply chain at any tier' as opposed to only ostensibly 'risky states.' This theft is complicated by the presence of a foreign national in the critical path, a fact that we continually flag to firms placing IP-rich R&D hives in China, which often pose a greater IP risk than in-country manufacturing operations.

The theft, as great as it was, was "probably just the tip of the iceberg"

"National interest [was] at risk" given the nature of Denso's research and engineering

"Denso's data management clearly was lax" allowing damage to Japanese interests beyond the confines of Denso

"Anti-espionage laws [are] lacking" even as the "National Police Agency believes China is trying to obtain various advanced technologies and related information in Japan"

"Employment of foreign engineers and researchers" needed national as well as corporate oversight

Management of important corporate information is not an issue "that can be left to the private sector alone"

As the Japanese Penal Code only stipulates a maximum five year sentence for embezzlement, the "police reportedly also plan to establish a case under the Unfair Competition Prevention Law as it provides for a heavier [ten-year] punishment"

Little more was published in the Japanese press until small items appeared two weeks later in Japan Times; Japanese magistrates and police had withdrawn charges and released the Chinese engineer that executed the "national security" level IP theft against Denso. The anemic refusal to indict and the release notices (verbatim below as they have now scrolled off) are mind-boggling in their banality, and there has been nothing more from official sources since. Astonishing until one considers the leverage that China could apply against Denso and Toyota:

Prosecutors decide against indicting Chinese man over data theftJapan TimesApr 6, 2007Requested articlehas expired, and is no longer available

NAGOYA - The Nagoya District Public Prosecutors Office on Thursday decided against filing a formal charge against a Chinese employee of auto parts builder Denso Corp who was arrested on suspicion of taking out product design data without the company's authorization, investigative sources said. The prosecutors apparently decided it was difficult to establish a case...

Prosecutors release Chinese man over data theftKyodo News, Japan TodaySaturday, April 7, 2007 at 07:16 EDTRequested articlehas expired, and is no longer available

NAGOYA - The Nagoya District Public Prosecutors Office on Friday released a Chinese employee of auto parts maker Denso Corp who was arrested on suspicion of taking out product design data, with a view to suspending indictment against him.

The release of Yang Luchuan, a 41-year-old engineer at the company based in Kariya, Aichi Prefecture, marked the end of the case, with investigators unable to confirm why the data was taken and whether it was handed over to other people.

The affair has been whitewashed. My immediate impression was that Cisco's manhandling by Huawei and the PLA had repeated itself, and for the same reason: threats of extralegal punishment in the Chinese market.

Huawei Shenzhen Technology Company. Huawei was founded in 1988 by Ren Zhengfei, a former director of the PLA General Staff Department's Information Engineering Academy, which is responsible for telecom research for the Chinese military. Huawei maintains deep ties with the Chinese military, which serves a multi-faceted role as an important customer, as well as Huawei's political patron and research and development partner. Both the government and the military tout Huawei as a national champion, and the company is currently China's largest, fastest-growing, and most impressive telecommunications-equipment manufacturer...

In analyzing the dynamics of the IT sector, it is first necessary to divide the defense portion of the IT sector into two related but distinct categories. The first includes those subsectors providing the PLA with commercial-off-the-shelf IT systems, such as routers, switches, and computers, which have become increasingly central to the digitization of the U.S. military. Key companies in this category include such "red chips" (the Chinese equivalent of U.S. blue-chip companies) as Huawei, Zhongxing, Datang, Julong, and the Wuhan Research Institute, all of which are private companies spun off from state research institutes that enjoy national-champion preferences within the system. They are marked by new facilities in dynamic locales, such as southern and eastern China, a high-tech workforce, and infusions of foreign technology. These firms are not obligated to provide a social safety net for thousands of unemployable workers and their families in rural areas. Instead, they hire and fire staff using market-based incentives and stock options...

The two most important categories of Chinese IT firms, particularly in dealings with foreign multinationals, are telecommunications equipment and electronics. Publicly, the major players in telecommunications - Huawei, Datang, Zhongxing, and Great Dragon (Julong) - appear to be independent, private-sector actors. By contrast, many of the electronics firms are grouped under ostensibly commercially oriented conglomerates, such as China Electronics Corporation. However, one does not need to dig too deeply to discover that many of these electronics companies are the public face for, sprang from, or are significantly engaged in joint research with state research institutes under the Ministry of Information Industry, defense-industrial corporations, or the military. Indeed, each of the "four tigers" of the Chinese telecommunications equipment market (Huawei, Zhongxing, Datang, and Julong) originated from a different part of the existing state telecommunications research and development infrastructure, often from the internal telecommunications apparatus of different ministries or the military. These connections provide channels for personnel transfers, commercialization of state-sponsored R&D ("spin-off"), and militarization of commercial R&D ("spin-on")...

Huawei has also become the most successful Chinese exporter of equipment, entering international markets in 1996. According to one source, "For the future, Huawei wants to be the Cisco of the PRC, but also is ambitious to become a global player." The company is rapidly penetrating Africa, Russia, India, and many other areas ignored by Western telcos...

The digital triangle approach resembles a classic technonationalist strategy a la Japan, with high-level bureaucratic coordination and significant state funding. But it also has the attributes of market-based, dynamic, nimble, and internationally oriented private enterprises. The techno-nationalist strategy has been attempted by the defense-industrial system in China in the past; that it is currently successful in information technology and shipbuilding may be driven more by the integration of those sectors into the global R&D and production chain than by China's technological strengths per se.

The digital triangle represents an important evolution in the military's strategy for telecommunications development. Under the previous model, such companies as the PLA General Staff Department's China Electronic Systems Engineering Corporation (CESEC) built commercial networks and served as a front company for the acquisition of technology for the military. Private Chinese companies such as Huawei, by contrast, represent the new digital-triangle model, whereby the military, other state actors, and their numbered research institutes help fund and staff commercially oriented firms that are designated "national champions," receive lines of credit from state banks, supplement their R&D funding with directed 863 money, and actively seek to build global market share. The military, for its part, benefits as a favored customer and research partner. Companies such as CESEC continue to exist, but they now serve as systems integrators of technologies from multiple outside vendors...

As part of its backbone infrastructure work with the PLA, Huawei supplied secure fiber optic communications networks widely within the PLA, its missile networks and fire control/command and control systems, and would supply a variant, Tiger Song, to Iraq prior to OIF which greatly complicated US interdiction as previous Iraqi anti-air comm had been interceptable, targetable transmissions. The PRC was one of many UN embargo violators (which included our allies France and Germany as well as Russia):

Iraq purchased a number of Chengdu F-7 fighter jets from Beijing and has managed to trans-ship spare parts made in China for its force of F-7 and MiG-21 fighters through illegal front companies in Jordan, Hong Kong and Singapore. China also supplied Iraq with a large number of T-55 and T-58 tanks equipped with modern night-vision gun sights and laser range-finding systems. Somehow, the Iraqis keep these tanks in tip-top condition with an ample supply of Chinese-made spare parts. It is well known that China sold Iraq the "Tiger Song" air defense system during the 1990s. Both [Powell] and [Rice] have stated that China sold Iraq its new air defense system. The sale took place despite the fact that China also signed on to the U.N. ban on weapons sales to Iraq. NATO gave the system its name in 1998 after it was discovered to be operational in the Iraqi desert.

In 1994, Professor John Lewis of Stanford University... teamed with General Ding to buy an advanced AT&T fiber-optic communication system for "civilian use" inside China. According to the Far Eastern Economic Review, [Perry] wrote a letter to US Government export control officials, favoring the fiber-optic export to China. The venture was called "Hua Mei." The Chinese part of the venture was run by the newly formed firm, "Galaxy New Technology," with General Ding's wife, Madame Nie Li, as the head of the project.

With the support of Perry and the advice of Prof. Lewis, AT&T shipped the secure communications system directly to a Chinese Army unit, using Galaxy technology as a front. The so-called "civilian" Galaxy firm was packed with senior Chinese military officers... Madame Nie was not only the wife of General Ding, but actually Lt. General Nie Lie of the Chinese Army. Galaxy Director and president was Mr. Deng Changgru, also known as Lt. Colonel Deng Changru, head of the Chinese Army communcations corps. Co-General manager of Galaxy, "Mr." Xie Zhichao, also known as Lt. Colonel Xie Zhichao, director of the Chinese Army's Electronics Design Bureau...

"The Chinese army's Electronics Bureau... modified the American fiber-optics communication system, changing it into a secure air-defense system. The Chinese military then exported the newly modified system to Iraq. The Iraqi air defense network, NATO code-named "Tiger Song," is made of US and French fiber-optic parts modified by the Chinese military."

Today [2001], Iraqi anti-aircraft missiles, guided by Tiger Song, regularly target US fighter planes. And following the recent US-British attack on the system, Chinese military engineers are reportedly repairing damages to the system.

Cisco eclipsed by Huawei's theft of IOS

Had Cisco performed a competent due diligence, it would have known that its arms were too short to box with God. Instead, it soldiered ahead as if an award in US jurisdiction would protect "its IOS software package, which lies at the heart of many of its box designs":

It is the first-ever intellectual property lawsuit for Cisco, and one senior Cisco officials had tried to avoid by consulting with both Huawei and Chinese government officials...

Mark Chandler, Cisco's general counsel, said the main reason for the suit was the discovery that Huawei was using the same source code for the software powering its routers. The code, called IOS (internetwork operating system), is the crown jewel of Cisco's technology. "Over the past year we had more and more of a case," he says, citing such things as the identical command lines and user manuals between Cisco and Huawei products. "But several months ago we realized the source code was copied--that's when we began direct negotiation." Huawei officials were receptive to negotiations, he said, but never changed their practices.

Chandler says Cisco hopes for what he termed "a recognition by Huawei that its conduct is unacceptable," ending the need for the suit...

But, you have to wonder if a victory in the US will lead to a worldwide victory for Cisco. Clearly, the battle in the US will be the first in a set of lawsuits the company files against Huawei. The real battleground will be in China. While Cisco has the edge in the US, the advantage balance shifts quickly to Huawei in the Chinese market. Even with a US victory, Cisco will likely fight a long uphill battle to try and convince China to rule against Huawei. And, if they win, they'll fight an even more tedious battle trying to get China to impose sanctions against Huawei...

Even if the US comes to the aid of companies to protect IP infringements in China, there's no guarantee that the infringements will stop. And if a communication giant like Cisco, with its deep legal pockets, can't stop Chinese companies from infringing on IP, how can any comm company targeting the market expect to protect its IP from Chinese pirates...

And then it was over with this fig leaf that did not fool the knowledgeable:

Huawei will continue to abide by the terms of the preliminary injunction order made by a district court in Texas in June. This injunction served notice on Huawei to stop its alleged use of Cisco router code.

Addressing Cisco's concerns about alleged piracy, Huawei has voluntarily made changes to some routers and switches. The two companies have agreed on a process for reviewing these changes. Provided the review confirms that the agreed changes have been made, the two sides will draw a line under the dispute.

All other terms of the agreement are confidential - so we don't get to know how much (if any) money changed hands.

Past Chinese practices and anecdotal evidence bolsters our belief that Cisco was threaten with extralegal penalties that would threaten its ability to do business in the PRC, i.e., revenue, access, and market position. Cisco effectively capitulated; Huawei made no fundamental code changes, nor did it stop shipping any product and it continued to undersell Cisco by a third.

It is asking much of a commercial firm to be as aware of foreign military needs reacting to changing geopolitical climates when (a) the firm is not focused on, and aware of, collectors' ability to harvest its IP, generally with impunity, and (b) the firm is focused on its perceived commercial competitors, and may be doing a greater or lesser job of maintaining its position and placating its stakeholders.

Still, Cisco's experience is instructive for the need of just such an external awareness and the tools to match. As previously noted, the 2005, 2006 and 2007 issues of Military Power of the People's Republic of China indicate the galvanic shock that Desert Storm, Operation Iraqi Freedom (OIF) and Kosovo had on Chinese military and geopolitical thinking. Achievement of C4ISR (Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance) became a PLA mantra and Cisco was a foundation toolset to that end.

Denso's global sales and net income for the fiscal year ended March 31, 2007, was $30.6 billion USD and $1.7 billion USD respectively, of which Asia and Oceania provided $4.1 billion USD in sales and an operating income of $388.8 million USD. Strong vehicle production in China contributed significantly to its Asian figures.

Q. Where is Denso's biggest growth area worldwide?A. The U.S. has already grown quite a bit. But Europe will lead the pack... The No. 2 market would be China.Q. How important is China for Denso?A. The amount of cars on the road will double in only few years. A country like that does not exist anywhere else in the world. We want that new business in China. We consider China a very, very important country.One problem though is the OEM mix is very, very complex. First Auto Works [FAW] has a joint venture with both Toyota and Volkswagen. It was in the media that Toyota would start a new joint venture with Guangzhou Automobile Group, which has a joint venture with Honda. There are a number of activities going on that cannot be seen anywhere else. We are carefully monitoring those moves.Q. Is your strategy for local production or export?A. We want to manufacture in China for the growing market there. Export is not an issue... We want to maintain our principle of making products where our customers exist...Q. What Is the next market for diesel growth?A. China will be next. Engines in large size, buses and trucks are becoming modernized. So the desire is for high performance, high efficiency engines while making them more compact. China always demands the latest technology. We are trying to bring to China--diesel's newest technology--the commonrail technology...

And Denso can never be viewed in isolation from Toyota; pressure on one is pressure upon the other. Unlike China's positive trade balance with the US, China has a "heavy negative trade balance" with Japan and Korea principally due to:

Presence in China of Japanese and Korean OEMs "importing parts from home"

Protectionist measures from Japanese and Korean domestic auto part industry to limit imports (especially Japan)

Toyota commenced in-country production of the Camry in Nansha in May 2006:

Toyota joins a rush by the world's automakers for a share of China's auto market, which saw sales jump by 30 percent last year and is poised to overtake Japan as the world's No. 2 market. Toyota, a relative latecomer to China, had a paltry 3.5 percent of the market last year, with 179,000 vehicles. That puts it well behind top foreign automaker General Motors Corp., which vaulted past Volkswagen AG of Germany to grab 11 percent of the market last year...

Toyota began exporting to China in 1964 but lagged behind rivals in focusing its ambitions on the Chinese market, choosing instead to concentrate on the markets in the United States and Europe. It wasn't until 2002 that it rolled out its first locally produced, Toyota-brand car with a Chinese partner, state-owned FAW Group Corp...

[Toyota] says the [Nansha] facility brings its most advanced technology to China -- a step sought by Chinese leaders as they try to build up a world-class auto industry...

The new Nansha factory also has drawn a group of parts suppliers such as Japan's Denso Corp., which said Tuesday it will spend 30 billion yen (US$265 million; ?210 million) over the next five years to shift production to China...

Despite political tension between Japan and China that flared into riots last year, Japanese automakers are heavily investing in China, and last year pumped a total of 113.7 billion yen (US$1.03 billion) into the country.

Both Denso and Toyota are now committed to China out of necessity and that footprint brings risk. I cannot imagine either Denso or Toyota sliding into the 1st China International Auto Parts Expo (29 Nov - 1 Dec, 2007) in Beijing in a confrontation over a "national security" level theft in trade secrets and Intellectual Property from one or more Chinese entities that would in all likelihood involve PLA assets.

The moral is: prepare in advance to defer and deflect predations upon your IP as once the theft occurs there is little recourse under the best of circumstances, and in the face of extralegal sanctions, likely zero.